Brexit: A long and winding road

June’s unexpected Brexit vote has opened Pandora’s Box. One question has been answered, only to be replaced by myriad unknowns. While the UK voted against being a member of the EU, it is unclear what exactly it has voted for. While a new Conservative prime minister has been appointed, the new shape of the UK’s relationship with the EU will not be known for many years. This will weigh on the UK economy and is likely to periodically rattle financial markets for some time to come.

Political upheaval

Having made the momentous decision to leave the EU, the UK was plunged into political uncertainty. David Cameron, the prime minister who had campaigned for the Remain side, immediately resigned in the belief the country needed new leadership following the Brexit vote. The Conservative Party was primed for a hotly contested leadership race lasting until September, but the sudden withdrawal of the pro-Leave candidate, Andrea Leadsom, paved the way for Theresa May to be sworn in as prime minister within a matter of days.

While new leadership helped to reduce political uncertainty, the question of how Prime Minister Theresa May will handle Brexit remains unanswered. From her statement that, “Brexit means Brexit and we are going to make a success of it,” the early indication is that she will listen to the will of the people. No one knows for sure the path she will take, but it’s considered unlikely she will invoke Article 50 of the Lisbon Treaty – which would set the UK’s exit from the EU in motion – before the end of this year.

What we do know is that May and her Conservative Party have a relatively free rein in forming the UK’s Brexit strategy given that the Labour Party is in disarray and depriving the country of a credible opposition. Labour leader Jeremy Corbyn, blamed for a poor endorsement of the Remain campaign, managed to resist a vote of no confidence but then faced a hostile leadership challenge from Angela Eagle, the former shadow secretary of state. Here too, a new leader may emerge.

A roadmap to Brexit

Despite uncertainties, it can be useful to map out a plausible process for what lies ahead. Prime Minister May’s options are to either unilaterally trigger Article 50 or seek parliamentary approval for submitting the request to leave the EU. Given the referendum was not legally binding, it is more likely parliamentary approval will be sought. How the 650 MPs vote will therefore be crucial.

The House of Commons is largely pro-Remain, although Conservative MPs are expected to support their leader and regard the 51.8% referendum vote for Leave as expressing “the will of the people.” One potential outcome is a confidence vote and then a general election if a small number of Conservative MPs rebel and vote according to their personal preferences on the grounds the referendum result was too narrow. Observers assign a low probability to this outcome.

Connect with a relationship manager

Don’t have an RBC relationship manager and wish to find one? Let us match you with one.

While the UK may be willing to start negotiating the terms of the new relationship now that a new prime minister has been installed, the EU has ruled out even soft negotiations until Article 50 has been formally activated. Moreover, with general elections in France and Germany in 2017, European leaders may want to stall the negotiations – so too might May. The UK does not have a strong negotiating position, given that it loses several trading relationships representing half its exports in one go, while the EU, which sends a mere 10% of its exports to UK shores, loses only one.

Brexiteers currently aim to maintain access to the single market while restricting the free movement of labour, a key pillar of the EU, and without contributing to the EU budget. There is no precedent for such an arrangement, and it is difficult to see how this may be agreed to early or quickly, if at all. The EU will not wish to set a precedent that could encourage other EU members to seek changes to existing arrangements. The longer the delay in triggering Article 50, the more the reality of an unmoored Britain may sink in, possibly making a compromise easier to reach.

The UK could opt for membership of the European Economic Area (EEA), the so-called Norway model, retaining access to the single market in exchange for a contribution to the EU budget and free movement of labour, but no say in EU politics. Many question the advantage of that arrangement over the previous model. Alternatively, the UK could be adamant about rejecting the free movement of labour and accept restricted access to the single market (i.e., excluding some services or some goods).

Once negotiations with the EU are concluded, all remaining 27 EU nations and the UK will have to ratify the outcome, either through their respective parliaments or by referendum. Whatever path is taken, a time limit could be imposed, perhaps five to 10 years, after which the UK could decide to continue with the arrangement or opt out of the EEA and seek a complete exit through bilateral agreements. We expect the negotiations to be lengthy, tricky, and to weigh on economic activity.

Moreover, other negotiations will need to take place. The UK will have to negotiate trade arrangements with over 50 countries that the EU has trading relationships with, as they will no longer apply once the UK exits the EU. The government no longer has a deep pool of expertise to deal with trade issues given the EU has long handled these matters. The newly established Brexit Unit of the UK government will have its work cut out.

Slippery slope economy

Given the lack of clarity on the path ahead, there is an unusual amount of risk associated with any economic forecast. Nevertheless, one can surmise that this level of uncertainty will dampen growth. A mild recession in the UK is likely to begin in the second half of 2016. Business investment, already weakening prior to the vote, is likely to deteriorate even further. Hiring decisions are likely to be postponed, while households may hold back on purchases.

Sam Hill, senior UK economist at RBC Capital Markets, has lowered his 2016 GDP growth forecast to 1.4% from 1.8%. For 2017, he expects GDP growth of 0%, down from 2.1% previously. With the growth background threatened, the Bank of England (BoE) hinted that further monetary policy easing is a possibility, although it held off cutting interest rates at its July meeting so that it could collect more evidence of the negative impact of Brexit before making a decision. Hill says the BoE wants to “take a bit longer to assess the best combination of tools to use given financial stability considerations” and forecasts an interest rate cut of 25 basis points in August.

As the pound weakens due to Brexit uncertainty, inflation is expected to increase. However, any increase may prove transient as the deflationary effects of the economic slowdown take root. Despite a weaker pound boosting exports, lower business investment could lead to a sharp deterioration of the balance of payments. The UK runs a current account deficit of more than 5% of GDP, the largest in the developed world. Much of this has been financed by foreign direct investment (FDI) given the attraction of the UK’s legal system and position in the EU market. Should FDI dry up, the currency will have to weaken further to redress the balance. While this might boost the UK’s net trade position, it is unlikely to offset the drop in business spending.

Eric Lascelles, chief economist at RBC Global Asset Management, expects higher tariffs, less immigration, and that the slight diminishment of London as a financial hub could shave as much as a quarter percentage point off growth annually over the coming decade. Potential savings on transfers to Brussels and greater regulatory sovereignty may help but are unlikely to compensate for these factors completely. Any assessment significantly depends on the new relationship the UK is able to negotiate with the EU.

Adapting…again

The Brexit vote has changed the course of history for the UK. But the country is no stranger to these abrupt changes. The loss of the 13 colonies in the 18th century heralded a period of instability for the UK before it recuperated. As politicians begin to unravel the current relationship with the UK’s largest export market, the domestic economy will bear the brunt of the change and ensuing uncertainty. It will take several years before a new relationship is established.

This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.

The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgements as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.

This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.

Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £50,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.

We have detected that JavaScript is disabled on your browser

www.rbcwealthmanagement.com is using JavaScript to ensure the best experience through the site. Please check http://www.enable-javascript.com/ to learn how to enable JavaScript on your browser and enjoy the best experience.